A Tale of Two Economies

Is an “old economy” mindset skewing how investors perceive the state of the global economy?

Given the dramatic decline that occurred in many cyclical asset prices this year, it’s a bit understandable that markets have developed a preoccupation with the increasing risk of recession.

We at Morgan Stanley’s Global Investment Committee—a group of seasoned investment professionals who meet regularly to discuss global economy and markets—acknowledge such concern is valid, especially since we are late in the economic cycle.

However, while the threat of recession is definitely a growing concern we think it is a bit premature.

Reacceleration in cyclical asset prices

In addition to tracking economic data and leading indicators for early warnings signs of recession, we at the GIC also listen to the markets because they often see the future better than any of our models.

So when cyclically sensitive asset prices declined this year, it certainly got our attention. However, just as weak cyclical asset prices warned of the summer slump, they may now be warning of a sharp reacceleration.

These same assets are now leading the price recovery ever since the equity markets successfully retested their August lows in late September. This is a good sign—and something we at the Committee anticipated.

So far, most pundits have suggested the rally in emerging markets, commodities, economically sensitive equities and high yield is simply a bounce from an oversold condition or traders covering their short positions. We are taking a more open-minded approach and think the rally in these assets could persist longer if we are right about global rebalancing. The economic recovery could even become more sustainable in the process—albeit at a low level.

The point is that if recession is avoided, cyclical asset prices will likely rise further to reflect this more benign outcome. However, there is another interesting point to be made about recession fears and why they are so real to many market participants.

Asset prices and the old economy

For the past 50 years, economists have come up with various tools and indicators that tell them when growth is about to roll over or accelerate. Many of these tools were developed when the economy looked a lot different than it does today.

50 years ago, the US and global economy was largely driven by manufacturing and industrial activity. Today, we are much more of a services and consumer-driven economy, not just in the US, but all over the world.

To be specific, the developed world is 70% consumption and services-oriented. With the evolution of information technology and the internet in the past two decades, this trend has only accelerated. Think about how many $100 billion businesses have been created in the last 20 years that have virtually zero tangible assets or manufacturing capabilities. Many of the established economic tools don’t capture this part of the economy properly and overdiscount the signals coming from the old economy.

The reality is that the old economy is in recession and that might be having a disproportionate impact on investor perception around the broader economy just like it had on the asset prices most sensitive to the old economy.

The spread between the manufacturing and nonmanufacturing economic surveys has rarely been wider. In the past when manufacturing inventories were this high and/or orders were this negative, we always had a recession. However, consumer confidence and spending remain robust and are still accelerating, suggesting the overall economy can hold up.

It’s worth noting manufacturing inventory/sales and new orders growth appear to have reversed and passed the worst part of the slowdown, which means stocks should start to discount the likely recovery, especially in the beaten-up areas. That seems to be exactly what the market is telling us. We at the Global Investment Committee are listening.